Data and distribution plays will power payment networks' inorganic growth strategies

High levels of inertia and strong network effects have allowed payment networks like Visa and Mastercard to remain as central and very profitable pillars of the card payments ecosystem for the past several decades. However, the deep moats they've created are increasingly being challenged by emerging technologies and providers. While credible threats remain further on the horizon, there is an impetus for payment networks of all types – global networks like Visa, debit networks like PULSE and regional networks like Interac – to augment their heavy reliance on transaction fee revenue by investing in technology and services. This report explores a variety of inorganic growth avenues that payment networks should consider to further enhance their value and maintain continued relevance.

The 451 Take
Payment networks must evolve beyond their primary role as transactional switches to ensure their position at the heart of electronic payments and, ultimately, drive continued growth. To do this, they must begin to encompass a broader value proposition that increases their utility for bank partners and, increasingly, retailers. Future success will be in part tied to the networks' ability to leverage their massive transaction databases to move deeper into adjacent, value-added areas like advertising and digital identity. The networks will also find growth, as they always have, through expansion of their acceptance network, which we believe will largely be fueled by the growing roles of software developers and the migration of commerce to myriad connected endpoints over the next decade. We anticipate that inorganic growth will play an increasing role in helping to drive these digital transformations and position the networks more as commerce technology vendors and less as transaction facilitators in time.

The evolving roles of the payment networks
Payment networks have traditionally held three fundamental roles within the card payments ecosystem. These roles include:

• Establishing rules – The networks establish rules of engagement that issuing banks (the cardholder's bank) and acquiring banks (the merchant's bank) must abide by to participate in the payments system. These rules take a variety of forms, and tend to be either technology-oriented (such as setting ecosystem migration timelines for EMV) or process-oriented (such as rules for how to handle cardholder disputes and chargebacks).
• Operating as transaction switches – A chief role of any payment network is to serve as an intermediary between issuing and acquiring banks to ensure that payments flow efficiently between both parties. This allows an acquiring bank (e.g., Bank of America Merchant Services) to facilitate a transaction with an issuing bank (e.g., Citi) in milliseconds without either party having to directly communicate or integrate with each other.
• Brand-building – One of the most critical responsibilities of a payment network is to establish a highly visible brand that consumers synonymize with card acceptance. Fueled by vast marketing budgets, payment networks invest heavily in their brand through tactics like sponsorship and advertising.

A confluence of market forces is beginning to test these competencies, however. For instance, blockchain is being heralded by some as a conceivable replacement for centralized intermediaries in the transaction flow while certain digital wallets (e.g., Starbucks, Chase Pay) are designed to limit network dependencies. Further, technology firms such as Apple and Google are beginning to 'brand' payments (ever notice an Apple Pay logo next to a Visa and Mastercard logo at checkout?) and central infrastructure operators are migrating to real-time payment systems globally (e.g., Faster Payments in the UK), encouraging direct bank-to-bank fund transfers.

As expected, the payment networks have not remained complacent in the face of these evident and perhaps existential threats to their businesses. They are investing heavily to position themselves as technology and service providers to play a deeper and more strategic role in the payments value chain. It may be surprising to learn that Mastercard, for instance, already generates 25% of its revenue from non-card-related activities.

Given that banks are the networks' core constituencies and customers, many of the networks' investments are designed to equip banks with enhanced digital capabilities to increase their competitiveness (and continued reliance on the networks, to be sure). Visa and Mastercard's multi-hundred-million-dollar investments in their tokenization platforms and launches of their respective digital wallets, Visa Checkout and Masterpass, are prime recent examples of the steps networks are taking to digitize both their businesses and those of their customers.

Past M&A activity
Historically speaking, inorganic growth has played a noted role in the ongoing digital strategies of payment networks. Interestingly, three out of the four major global networks – Visa, Mastercard and American Express – have demonstrated a tendency to execute high-profile, related deals in succession of one another. For instance, in 2010 each of the networks made moves to further their reach into e-commerce acceptance with gateway transactions: Visa bought CyberSource for $2bn, Mastercard acquired European payment service provider DataCash Group for $520m and American Express nabbed Accertify for $150m. In late 2016 and early 2017, the trend reemerged with transactions oriented around card-not-present security: Visa purchased CardinalCommerce for $300m, Mastercard snagged NuData and American Express reached for InAuth.

Mastercard has been among the most active suitors in this space, with over 10 deals inked in the past five years, according to 451 Research's M&A KnowledgeBase. Its most recent landmark transactions include the $600m pickup of analytics provider Applied Predictive Technologies (APT) in April 2015 and the $920m acquisition of real-time payment software vendor VocaLink in July 2016. Also of note is Mastercard's purchase in July of artificial intelligence specialist Brighterion, which when viewed in conjunction with its APT buy highlights the emphasis it is placing on data.

Visa and American Express have been relatively quiet in recent years on the M&A front, although Visa's acquisition of advertising enablement vendor TrialPay in February 2015 played a pivotal role in building out the recently launched Visa Commerce Network. Discover Financial Services has only inked one major deal since being spun off from Morgan Stanley in 2007, handing over $165m to Citigroup for Diners Club International in 2008.

Elsewhere, smaller, more localized and specialized networks have become targets themselves. Nets Holding, for instance, which operates in the Nordic countries, was acquired for $5.3bn by private equity firm Hellman & Friedman in September. Debit and ATM networks have also been targets, with Mastercard and Visa placing bets in the late 1980s and early 1990s (Cirrus and Interlink, respectively), and Discover adding PULSE in 2004.

Potential targets
We believe payment networks' future M&A strategies will largely focus on data and distribution plays, which will help generate new revenue streams and expand acceptance. In particular, we see the following categories showing strong potential for near- to midterm consolidation activity:

Developer, application and API management platforms

Major payment networks around the world are in varying stages of building out developer portals (e.g., Visa Developer) that are designed to improve access to their services via the use of APIs. These initiatives are largely in response to the growing importance of the new and largely nontraditional partner ecosystem (e.g., Apple, Fitbit, Google) that is responsible for driving payments into the digital economy. By opening up their networks, these companies hope to improve their distribution and reach in digital commerce while helping their bank customers streamline integration of next-generation technologies. To galvanize their strategies, vendors with developer, application and API management platform assets could serve as attractive targets.

Plaid would serve as a natural fit given that it provides a banking data API that allows financial service developers to connect with customer bank accounts. This would be a particularly useful capability for a network like Visa or Mastercard looking to help bank clients adhere to the PSD2 regulation in Europe. In the same vein, Token provides an open banking platform well suited for PSD2 migrations and would provide an asset that networks could repackage as part of a broader digital-transformation offering for their issuing partners. Other targets could include more enterprise-focused mobile back-end-as-a-service vendors such as AnyPresence, Built.io and DreamFactory.

Digital identity

The concept of digital identity is currently among the hottest topics in financial services. Banks are in a potentially unique position to leverage their competencies in consumer trust, 'know your customer' and risk management to serve as an identity broker for their customers by enabling trusted access to third-party services and applications. With PSD2 hitting the European market in 2018, we believe the concept of the bank as a trusted identity provider is set to gain further traction. The challenge is that banks have an abysmal track record for new product development. (When was the last time you saw a new product from your bank?) We think payment networks are in a unique position to facilitate the exchange of digital identity on behalf of their bank customers given their centralized position and existing role as a connector.

Toronto-based SecureKey, which already counts Mastercard, Visa and Discover as investors, would serve as a natural target that could help execute on this vision. The company is working to build out a trusted identity network that leverages blockchain and has gained early traction among financial institutions and other participants in Canada. Another candidate would be Chain, which Visa invested in in 2015 and later partnered with on an international B2B payment service. The vendor offers an enterprise blockchain platform predominately focused on financial services. We could envision its technology being deployed in conjunction with a payment network to transfer identity credentials. Additional targets could include identity verification service providers such as Trulioo, Jumio and miiCard, which would serve as unique assets that could transform digital wallets like Masterpass into identity vehicles.

Advertising

It may be surprising to learn that the advertising business isn't uncharted territory for Visa, Mastercard or American Express, with each of the three networks already participating in this ecosystem to varying degrees. The optimal acquisitions for payment networks are those assets that can both leverage their existing transaction data for marketing applications and provide retailers – whom they are increasingly trying to justify their value to – with opportunities to derive returns from their own proprietary data. Owning a second-party data exchange – a product that enables two parties to trade, sell or buy each other's audience data – would fit both of these criteria.

OwnerIQ would be a logical choice, as the company specializes in retail data. Lotame, an audience data management platform provider, has such an offering as well, although it would come with a broader set of products that might not align with a payment network's objectives. Commerce Signals, which sells a service that enables data partners to mingle data by managing and automating the execution of data-sharing agreements, would also provide an asset that could help networks bring their data to market, while offering a monetization vehicle for retail partners.